Texas Titans

By

Neil A. Martin

Dec. 10, 2001 12:01 a.m. ET

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It's said that in the history of mankind, no one's ever raised a monument to a committee. If they ever do, they might want to consider a small group of growth-minded portfolio managers in Dallas who have successfully taken a team approach to investing. It's an approach that in today's highly volatile markets even value investors might admire.

Last year, for example, when most tech-laden growth funds were being hammered by a bear market, the five funds of John McStay Investment Counsel's Brazos funds posted positive returns ranging from 5% (small cap) to 35% (multi-cap) and outperformed their benchmarks and most of their peers by wide margins.

And during this extremely difficult year, when most growth funds are deep under water, the five Brazos funds have outperformed competitors impressively on a relative basis with single-digit negative returns. As of Thursday, the Brazos Micro-Cap fund was down by only 0.28% over the past 12 months, while the group's small and mid-cap products were off 5.22% and 4.65%, respectively, and the multi-cap fund was off 4.97%, according to fund-tracker Morningstar. The company's real-estate fund, on the other hand, was up by nearly 15.3%.

"Our investment process is designed to outperform," says McStay, founder and a managing partner of the Dallas-based money manager. "We are growth-minded, but conservative and diversified in our approach. We have designed our investment strategies to do well in a down market, as well as an up market, and to outperform over a market cycle."

The group's mutual funds and private-investment accounts have beaten their annual performance benchmarks since the firm's 1983 inception, and in three-, five- and 10-year segments: This year, while McStay's mid-cap growth competitors have generated negative returns of 23.42% on average since January, the Brazos Mid-Cap Fund is down by only 9.08%. That places it in the 17th percentile of the 638 funds surveyed by Morningstar. Since its inception in December 1999, the fund has had an annualized return of 9.54%, compared with a negative 13.89% for its mid-cap peers.

"There is no better example of someone who has successfully pursued an unwavering style with rigorous discipline than McStay," says Eric T. Miller, a private investment strategist based in Carmel, California. "From his beginnings in business, he's been an advocate of smaller-cap stocks and has thrived despite periods when those groups have been out of fashion. He has also weathered the rocky up and down cycles of the Texas financial industry."

A native of Vernon, Texas, with more than 35 years in the money business as an analyst and portfolio manager, McStay and his team of 10 portfolio managers currently oversee about $5.5 billion in assets. Over $1.5 billion of that is invested in the five mutual funds, and the rest in some 100 separate accounts.

While McStay declines to name his clients, published documents have mentioned the New York City Ballet, the Metropolitan Opera, the Doris Duke Foundation, the Mellon Foundation and steel company LTV's pension fund.

Brazos' mutual-fund business is only four years old, but mirrors the company's other accounts in both stock holdings and investment approach. The mid-cap fund has total assets of over $100 million, with another $600 million invested in mid-cap stocks for institutional accounts. The minimum to buy in, be it mutual funds or independent accounts, is $1 million. (Individual investors can buy the Brazos Funds with an IRA investment of just $1,000.)

McStay's portfolio managers pride themselves on their team approach to investing. In addition, each of McStay's 10 money managers is also an analyst who focuses on an individual sector, such as technology, finance, consumer goods, health care and energy. They share their experience, knowledge and information at daily investment meetings at the firm's Dallas headquarters. All stock picks are team-vetted before any buy orders are placed.

"We take a bottom-up approach, looking for small- or medium-cap stocks with good fundamentals and annual earnings growth of 20%-30% and sales growth of around 20%," says analyst-portfolio manager Brian Gerber, who follows the technology sector for the group.

"While each of us is a specialist in a certain sector, we also overlap each other by virtue of our background, experience and knowledge of companies and the market," Gerber says. "We are fortunate to have 10 seasoned professionals, any one of whom can be 'hot' in a given year."

The closely knit organization has seen few defections: McStay has lost only one money manager in the past 18 years, a fact that clients find comforting, he says.

Beyond data collection, Gerber and his colleagues spend considerable time out of the office, talking with top executives, analysts, short-sellers, venture capitalists, suppliers and competitors, all in the search for companies in which to invest. They look for those with "recurring revenues, starting off the quarter with a high percentage of those revenues already visible."

When the credit-reporting agency
Equifax
recently spun off
Certegy,
a leader in card-processing and check services, Gerber, who had owned the stock earlier, suggested the team look at it as a possible Buy.

"Even though everyone knew I was familiar with the company, our financial analyst, who follows other financial-processing companies, gave me 10 questions to answer before he would sign on for any Buy decision," Gerber says. Queries by other team members were fielded, and when the stock dropped to the mid-20s after the September terrorist attacks, Gerber bought it for clients' accounts. Now, Certegy trades in the 30s.

Sometimes recommendations are shot down by concerns voiced by one or more analyst-managers about a company's valuation or business environment. "If it is controversial within the team, it may also very well have valuation issues in the market too," adds McStay.

Fortunately that was the case with oil-trader
Aquila,
a competitor of the collapsed Enron. "Aquila was an example of the best house in a bad neighborhood," McStay says; "it was suggested that the stock could trade at 20 times or better its forward earnings. But it was felt by some that it should be valued as a commodities trader with a P/E of about 10, rather than being priced on its growth rate. We even had two separate meetings to discuss the stock but ended up deciding against it -- which with 20-20 hindsight was fortunate, seeing what happened to Enron."

"If we operated on an individual 'star' system, it would have been a major problem," he adds. "But our collaborative team approach saved us and our clients a lot of money. Sometimes two or three heads are better than one."

Currently, McStay is positioning his portfolios to capitalize on what he sees as a "spirited rally" in the stock market over the near term.

How spirited?

"Let's say 30% or more off the bottom and over the course of the next six months or so," he continues. "Approximately 15% of this move, or about half, has already been achieved," he says, adding that a combination of the steepness of the market's fall since the start of 2000, the amount of liquidity in the system, optimism normally associated with the start of a new year and "meaningful monetary and fiscal stimulus" should keep the rally going in the months ahead.

Against these prospects, McStay and his analyst-managers are focusing on small- and mid-caps in sectors like technology and software, health care, and financial institutions and services. "We are very selective," says McStay, "and need only 60 stocks to fill our portfolios, which in today's environment isn't a big problem."

One stock that has performed well for McStay's portfolios is specialty cooking-products retailer
Williams-Sonoma.
The investment group has owned the stock off and on, but purchased it again last April at 28.70, after a new CEO was announced. Now the stock trades in the high 30s.

"The stock has historically traded at a premium to its growth rate," says Gerber. "We believe the company can grow at a rate of 25% or better, since in the near term there are opportunities to improve margins," he adds. A P/E of 30 on next year's per-share earnings of possibly $1.50 would suggest a target price of 45, Gerber says.

Gerber is selectively buying small, fast-growing technology and software firms like
Check Point Software,
which develops Internet security solutions for enterprise networks;
Intersil,
which makes microchips for wireless-computer networking;
Polycom,
a global leader in the convergence of interactive voice, video and data communications; and
Qlogic,
which provides infrastructure for computer storage.

"We have followed all these companies over a period of time but have become interested in them lately because their stock prices have come down considerably from their 2000 highs," Gerber says. One pick he rates especially high is Affiliated Computer Services, a technology service company, which he's been buying since it went public in 1994 at under $10. The Brazos Mid-Cap fund bought the stock, which recently traded at 96.32, for under 44.

"ACS is very predictable, with earnings growth of 20% or better," says Gerber. "With a 30 P/E on next year's calendar earnings of $4, we are looking at a price target of $120."

Health-care products, technology and services is another big field for the McStay firm with holdings like
Biovail,
which is growing rapidly using proprietary time-release technology to create improved versions of brand-name drugs. "The company has been growing at rates well above 30%," notes Gerber.

McStay spends his spare time tending cattle and mending fences on his large Texas ranch -- and throwing the occasional Texas-style barbecue. Gerber collects antique German beer steins. "With pictures and words on the ceramic, each beer stein has a story to it and a lot of history," he says. "Sort of like stocks."

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